What Is Bad Debt Recovery?

Bad Debt Recovery Explained in Less Than 4 Minutes

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Bad debt recovery happens when payment is received for a loan that was deemed uncollectable. During this process, some or all of the debt may be paid back. This sometimes occurs after legal action has been taken to collect on the debt.

Bad debt recovery can also come from the sale of a borrower’s collateral. Bad debt recovery can help a lender regain lost income, but the process can be time-consuming and difficult for businesses. Find out more about how bad debt recovery works, some different types, and what it means for businesses and individuals.

Definition and Example of Bad Debt Recovery

Every business has to deal with delinquent and unpaid customer accounts. If someone owes you money that you’re unable to collect, that’s considered a bad debt.

Some collection efforts will be unsuccessful, but occasionally, a lender or business will receive payment on accounts previously deemed uncollectable; this is what’s known as bad debt recovery. Bad debt recovery sometimes happens because of legal action taken to collect on the debt. Other times, it comes from a sale of a borrower’s collateral.

For example, if a borrower becomes delinquent on an auto loan, the lender will eventually repossess the vehicle. The lender will sell the car, and the proceeds it receives are considered a bad debt recovery.

How Does Bad Debt Recovery Work?

A bad debt occurs when someone owes you money that you’re unable to collect. Collecting bad debts can be challenging, and businesses usually end up writing them off. But businesses must take certain steps to demonstrate they’ve attempted to collect on the debt. This can involve using a collection agency or taking legal action. And these collection efforts often continue to take place once the debt has been written off.

When a business writes off bad debt, it will report this loss to the Internal Revenue Service (IRS). To write off a business bad debt, you must show all of the following:

  • The debt is related to your business.
  • The debt is worthless.
  • You experienced an economic loss.

Similarly, if some or all of the debt is recovered, you must reverse this loss. If a business recovers some or all of a bad debt, it will report the recovered funds as part of its gross income for that year.

Types of Bad Debts

According to the IRS, there are two kinds of bad debts: business and nonbusiness. By understanding the differences between the two, you’ll know how to report bad debt recovery to the IRS.

You can deduct a business bad debt using Schedule C (Form 1040), Profit or Loss for Business, or on your business income tax return.

Business Bad Debt

A business bad debt is a loss incurred that’s created or acquired in a trade or business or closely related to your trade or business. As a business owner, you’ll deduct these bad debts from your gross income when figuring out your business’s taxable income.

The following are examples of business bad debt:

  • A loan to a client, supplier, distributor, or employee
  • A credit sale to a customer
  • A business loan guarantee

Nonbusiness Bad Debt

All other bad debts are considered nonbusiness bad debt. The debt becomes worthless when the circumstances indicate there is no reason to believe it will be repaid.

You must deduct a nonbusiness bad debt during the year it becomes uncollectable. To report a nonbusiness bad debt, you’ll fill out Part 1, Line 1 of Form 8949, Sales and Other Dispositions of Capital Assets.

Before the debt is considered worthless, you must show that you’ve taken reasonable steps to collect payment. However, it’s unnecessary to take the borrower to court if you can show that even a court judgment would be uncollectable.

Key Takeaways

  • Bad debt is money that is owed but cannot be collected.
  • Bad debt recovery occurs when partial or full payment is received for a loan deemed uncollectable.
  • This type of recovery can happen as a result of a third-party collections agency or legal action.
  • Lenders will sometimes sell off collateral to recover part of the funds lost.
  • Businesses report bad debt losses to the IRS, so if some or all of the funds are recovered, the business is required to reverse the loss.